Considering whether using perpetual or periodic inventory systems, is a first yet fundamental to take by a company before attempting to set up its inventory accounting. And this is also the case of accounting people when attempting to learn about journal entry for any transaction related to inventory, in the company.
Every business has products or services that it sells. Particularly companies that sell product (either a merchandising or manufacturer) have inventory that they need to track time-by-time. And the decision whether using perpetual or periodic accounting system could affects their day-to-day operation.
Some businesses track changes in inventory levels on a continuous basis, recording inventory increases and decreases with each individual purchase and sale to maintain a running total of the inventory balance—this is called a “perpetual inventory system”. Other businesses rely on quarterly or yearly inventory counts to reveal which inventory items have been sold, this is called a “periodic inventory system”. This post overviews both systems. Read on…
What System Should I Use, Perpetual or Periodic System?
It depends on some specific situations (or environment) your company typically has on its day-to-day operation. For better understanding let’s construct two different virtual companies with each typical situation.
Firstly, consider that you own a computer superstore. How’s the situation?
- Your biggest-selling items are desktops, computer screens, and Laptops.
- You advertise your weekly sale items on local TV stations, and your sales volume is quite heavy. You have 45 or even more salespeople who work independently of one another.
- You have found that customers get very upset if they come to buy an advertised item and you have run out.
In this particular business situation, would it make sense to keep a running total of the quantity remaining of each inventory item and update it each time a sale is made?
Yes, for such company you would need to use perpetual inventory system. The benefit of having current information on each inventory item would make it worthwhile to spend a little extra time to update the inventory records when a sale is made. This appliance store would probably use a perpetual inventory system.
With a perpetual system, inventory records are updated whenever a purchase or a sale is made. In this way, the inventory records at any given time reflect how many of each inventory item should be in the warehouse or out on the store shelves. A perpetual system is most often used when each individual inventory item has a relatively high value or when there are large costs to running out of or overstocking specific items.
Secondly, consider that you operate a small stationary and newsstand business in a busy metropolitan railway station. How’s the situation?
- Almost all of your sales occur during the morning and the evening rush hours.
- You sell a diverse array of items—newspapers, magazines, pens, snacks, and other odds and ends.
- During rush hour, your business is a fast-paced pressure cooker; the longer you take with one customer, the more chance that the busy commuters waiting in line for service will tire of waiting and you will lose sales.
In this particular business situation, would it make sense to make each customer wait while you meticulously check off on an inventory sheet exactly which items were sold?
No, for such company you won’t use perpetual, instead you’d better use periodic inventory system. The delay caused by this detailed bookkeeping would cause you to lose customers. It makes more sense to wait until the end of the day, count up what inventory you still have left, compare that to what you started with, and use those numbers to deduce how many of each inventory item you sold during the day.
This railway stationary and newsstand scenario is an example of a situation where a periodic inventory system is appropriate. With a periodic system, inventory records are not updated when a sale is made; only the dollar amount of the sale is recorded. Periodic systems are most often used when inventory is composed of a large number of diverse items, each with a relatively low value.
On the next post, I will discuss about the different of perpetual and periodic inventory system in term with journal entries. With that, you will have a clearer picture of what you deal with in both systems so that at the end you will come up with the best decision whether using perpetual or periodic inventory system.